Charting the Calm Before the Storm

By

Michael Kahn

Aug. 16, 2001 5:43 p.m. ET

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The market "action" early this week looked like a yawner. Volume was way down, and breadth was narrow. Even Tuesday's better-than-expected retail sales report couldn't light a fire, and many retail stocks gave up their early gains to close lower on the day.

But on the same day,
Citigroup
announced it was trimming 3,500 jobs, while
Tyco
said it would cut its workforce by 11,000. The white horse on which the American consumer was riding to save the economy lost another big chunk from its hide. After all, no jobs, no spending.

It came on the heels of an important technical reversal last Friday. After breaking down below a critical intraday support level, the Nasdaq Composite index rebounded to shave its losses and close back above the key support of 1935 (see chart 1). This defined the bottom of a five-week trading range, and a breakdown there would have spelled disaster, with April's lows the logical next stop. So, everyone breathed a sigh of relief when it held.

Chart 1

Similar reversals took place on the other major indexes, but none had flirted this closely with a breakdown. The Dow Jones Industrial Average made a nice bullish reversal well above its support from July (see chart 2). The Standard and Poor's 500 and 400 (mid caps) both tagged their respective July trading range lows before reversing higher, so Friday was quite a good day for the bulls.

Chart 2

This week opened with some mild upside follow-through, albeit on low volume, but it was still just what was needed to forge a bullish short-term trend. Then came the doldrums.

On Tuesday, tech stocks rallied early on another bullish analyst's report, this one on the semiconductor sector, but it did not last. Now we have two bullish and two bearish proclamations about this sector. No wonder investors are still confused!

At Wednesday's closing bell, the Nasdaq and most tech-related indexes made their worst close since mid-April. The July-August trading range had officially broken down, even though other parts of the market were rallying. After a nice move up, the Goldman Sachs Software index is nearing its April lows once again (see chart 3).

Chart 3

Plus, the Philadelphia Stock Exchange Box Maker Index of computer hardware stocks has broken down below both its April 2001 and December 2000 lows, as well as below a major pattern on weekly charts (see chart 4).

Chart 4

Bottom line: The few tech stocks showing any signs of life are fighting a mighty strong tide.

Of course, other stocks besides technology are traded over the counter, and bank and insurance stocks have been soaring. But what if they pause to consolidate their gains? It's likely that the bottom will fall out from the Nasdaq Composite, so it makes sense to watch a small-stock index like the S&P 600 as an early warning sign (see chart 5). A breakdown in this index, one of the only broad-based indexes with a rising trend, would be devastating for the Nasdaq.

Chart 5

One more thing to keep in mind: For weeks, we have pointed out the persistently low levels in the CBOE Volatility Indexes (VIX, VXN) and what they say about investors' fear and complacency. When fear is rampant, the premiums paid for protective put options increase, thus driving up the volatility indexes. When there is no fear, the indexes are low. When they reach extreme lows, they become contrarian signals that a market top is imminent. We were close this week.

There is anecdotal evidence in the press showing that the public expects stocks to rally soon, regardless of the fundamental and technical evidence provided. An ad by a brokerage firm proclaimed this week that "fair value of the S&P 500 at the end of 2002 should be 50% above the index's level today." It was just like saying that "the train is leaving the station."

To be sure, bear markets do not end with optimism of this caliber. Bear markets end when nobody is interested in stocks any more. A major bear market might end with CNBC's ratings plummeting or the advertising in Barron's shrinking to historically low levels.

We are approaching what many expect to be the Federal Reserve's last interest rate cut in this cycle. Most experts anticipate a token 25-basis-point reduction, and the U.S. Treasury bond market has begun to lose steam. Lower interest rates, or the perception of lower rates, are good for the bond market. Hence, it would seem that bond traders believe that most of the gains in bonds already have been made. For stocks, this means they will lose one key leg of support -- continually lower interest rates.

As always, there are still pockets of interest. For those who are nimble, energy stocks have perked up because of last month's short-term breakout in crude oil prices (see Getting Technical, "Markets Still Move in Fits and Starts," August 8, 2001). Domestic producers are leading the pack, and stocks like
USX Marathon Oil
look strong (see chart 6).

Chart 6

So, is it time to go bargain hunting? Clearly, this market has not stabilized, let alone given signs that the bear is gone. To be fair, there are a few bullish signals, such as the new highs in the New York Stock Exchange's cumulative advance-decline line.

But price is the final arbiter, and it says in a loud voice: "Not yet."

Michael Kahn is Chief Technical Analyst for BridgeNews (www.bridge.com) and the author of two books on technical analysis, most recently Technical Analysis: Plain and Simple. He is also Director of Marketing for the Market Technicians Association (www.mta.org) and can be seen regularly on such financial news broadcasts as PBS's Nightly Business Report and Yahoo! Finance Vision (vision.yahoo.com).

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